When you start a business, one of the most important decisions you'll face is how your business will be taxed. The structure you choose not only affects how much tax you pay but also how you report income, handle expenses, and distribute profits. Here's a breakdown of the major business tax types in plain English.
The Two Primary Tax Models
There are two fundamental ways the government taxes businesses.
Pass-through taxation means the business itself does not pay income tax. Instead, profits "pass through" to the owners, who then report it on their personal tax returns. This is the model used by sole proprietorships, partnerships, LLCs (when not electing corporate tax status), and S corporations.
Corporate taxation (also called double taxation) means the business pays taxes on its profits at the corporate level. Then, if the company distributes profits to its owners as dividends, the individuals also pay tax on those dividends as personal income. This applies to traditional C corporations.
Tax Treatment by Business Type
| Business Type | Tax Method | Who Pays the Tax | Notes |
|---|---|---|---|
| Sole Proprietorship | Pass-through | Individual owner | Easiest to set up, but full personal liability |
| Partnership | Pass-through | Each partner pays based on their share | Requires a partnership agreement |
| LLC (Default) | Pass-through | Members (owners) | Can opt for corporate taxation if preferred |
| S Corporation | Pass-through | Shareholders | Must meet certain IRS eligibility rules |
| C Corporation | Corporate (Double) | Corporation pays; shareholders taxed again | Common for large and fast-growing businesses |
Key Terms Defined
Pass-through entity: A business where income "passes through" to the owner's personal tax return. The business itself doesn't pay federal income taxes.
Double taxation: This happens when a business pays taxes on its profits and then shareholders pay taxes again on dividends received. This is standard for C corporations.
Net income: The profit a company has left after subtracting all operating costs and overhead from its revenue. This is the amount that's taxed.
Example Scenario
Let's look at a business with these financials. This same example will be used throughout the series to make direct comparisons across different structures.
| Line Item | Amount |
|---|---|
| Revenue | $2,000,000 |
| Operating Costs | $1,000,000 |
| Overhead (rent, salaries, etc.) | $500,000 |
| Net Profit | $500,000 |
Now, imagine the business wants to distribute $250,000 of its profit. Here are three common ways this might happen:
1. Distribution to Owners (Pass-Through Entities)
This amount is not taxed at the business level. Instead, it's considered part of the owner's share of profit and taxed on their individual return.
2. Dividend to Shareholders (C Corporations)
The corporation first pays corporate income tax on the $500,000 profit. If it then issues a $250,000 dividend, the shareholders pay tax again on that dividend as personal income — this is what's known as "double taxation."
3. Bonus to Owner-Employees
If the owner is also an employee, the company can pay out the $250,000 as a bonus. This is treated as a business expense and reduces taxable profit for the company. The owner pays income tax (and possibly payroll taxes) on the bonus just like regular wages.
Why This Matters
Understanding how business taxes work can help you plan smarter, reduce surprises, and maximize what you keep. The right structure depends on your income level, how you intend to use profits, whether you have partners or investors, and how you plan to eventually exit the business.
Always consult with a tax advisor or accountant for advice tailored to your situation. Keiser Law works collaboratively with CPAs and financial advisors to ensure that your legal structure and tax strategy are working together.